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Underpinning the field of traditional finance is the assumption that people, when faced with financial decisions, act like computers. They weigh all the available information, calculate the option that maximizes their interests, and unemotionally implement their decision.Another school of economic thinking, known as behavioral finance, which combines insights from economics and psychology, offers a different theory: While it accepts the premise that people try to make rational, informed decisions that serve their self-interest, in reality they are subject to a variety of cognitive and psychological constraints that result in less than ideal choices and behaviors.
Among these constraints are three limitations in cognitive and behavioral abilities that prevent us from acting like a computer. These limitations, or “boundaries,” in human decision-making have spawned significant research into the areas of personal saving, spending and investing.
In the mid 1950s, Herbert Simon, a cognitive psychologist and Nobel Laureate in economics, introduced the principle of “bounded rationality.” In simple terms, bounded rationality presumes that humans lack the mental capacity to solve complicated, real-life financial problems, meaning some problems are simply too complex for individuals to solve quickly and correctly.
The implication is not that most people are unintelligent, but rather, …
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